The Case for Funds of Funds

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When I first started my journey of investing into funds at one of my last family office jobs, I quickly crossed paths with GPs whose main product was a fund of funds (FoF).

Inherently, I was sceptical. The funds of funds that I had seen in my previous banking jobs were quite disappointing performance-wise due to overdiversification. Even more importantly, they came at the high price of an additional management fee as well as a small carry, on top of the fees charged by the underlying funds. The result? Single-digit IRRs and long-term capital lock-up. Or in other words, a clear case where private equity would not be worth it.

But focusing solely on costs can be a dangerous proposition, especially in the world of private equity and venture capital. Just as individua top-tier funds can be absolutely worth their higher fees, so can a fund of funds be worth their additional fee layer as well. There are three areas to consider: simplification, diversification, and performance. (There’s also the topic of access - which will show up more than once.)

Today, let’s make the case for the Fund of Funds.

Simplification (and Access)

Accessing alternative asset classes such as private equity or venture capital can be a tricky position for affluent individuals. With total investable assets in the 10-20M€ range and a typical allocation to private equity of around 10-30%, clients find themselves with a target allocation of 1-6M€. And for investing in individual funds, that can be a challenging amount - for a number of reasons.

First, minimum ticket sizes. While I’ve had positive experiences around the minimum amount required to access good funds (admittedly not the truly outstanding ones), it is hard, if not impossible, to access high-quality, individual funds without a minimum ticket of 1M€/$1M or higher. 

Secondly, if you want to invest into individual funds, you should diversify across at least 3 or 4 funds per year. But not just in one year, but ideally across multiple years (‘vintages’) until your portfolio reaches ‘break-even’ (i.e. distributions are higher than capital calls on a calendar year basis). For a diversified fund portfolio, we’d expect 6-8 years. Until then, some early funds might’ve called all their commitment, while later ones might begin to be offset by early distributions. Using our internal models, we usually see net capital calls (i.e. capital calls minus earlier cashflows) of ~66% of total commitments until that break-even date - which gets us the following equation:

Total invested capital = years before break-even * annual commitments * 66%

And if we fill in our numbers, we can see that with 10-20M€ investable assets, you might end up with an allocation to your fund portfolio that might be bigger than what most investors are comfortable with:

6 years before break-even (in Y7) * 3M€ (3 funds 1M€ per year) * 66% = 11.9M€ in total invested capital

Finally, let’s change the equation and solve for what annual commitments we’d require to get to a 3M€ total investment:

3M€ total investment / (6 years * 66%) = ~760K€ in annual commitments

Assuming that you would still get into high-quality funds without absurd feeder fees, diversification across four funds wouldn’t be possible to a German investor given the 200K€ legal minimum (assuming you are a semi-professional investor). But you’d also find yourself spending an enormous amount of time dealing with the complexities of liquidity management, as well as ongoing accounting and tax matters. And especially for more entrepreneurially-minded individuals, your opportunity costs might be high - they might be better spent starting a new company rather than dealing with K-1 tax forms.

To be clear: It’s not impossible. We have some clients who have combined direct access and select feeder funds to build high-performing fund portfolios. But more likely than not, we’d assume that any excess performance from a portfolio of individual funds would be eaten up by direct costs (feeder fees), indirect costs (accounting and taxes), and implicit costs (time and efforts). 

One alternative would be evergreen funds with all their associated benefits and challenges (as we outlined in Part two of our series The Rise of Permanent Capital.) But if you want to stay with drawdown funds, you might be better off by instead choosing a fund of funds. In the ideal world, you can make just one commitment a year, theoretically starting at the aforementioned 200K€, but in this case here, perhaps being simply the ~760K€ annual commitment. With some FoFs being split across regions (i.e. Europe or US), you could also divide your annual commitment into two tickets, or simply alternate on an annual basis, as most FoFs also diversify across 2-4 vintage years.

Diversification (and Access)

In our view, a FoF provides significant diversification benefits across three different parameters:

First, there is manager diversification. As the name implies, a FoF invests in a number of underlying managers (typically somewhere between 8 and 16, in my experience). The GP managing the FoF typically attempts to combine those underlying managers in a way that adds value to the overall portfolio. For example, rather than investing in ten generalist managers, they invest in a number of specialized managers that individually would be more risky but taken together offset their underlying risks. They might also want to add managers that have different ways of generating returns, i.e. from your pure-play buyout manager in a certain industry, to more value-creation or buy & build focused GPs, to managers focusing on turnarounds and special situations.

(Some GPs diversify further by adding adjacent asset classes, i.e. a PE FoF that also does secondaries or co-investments. As co-investments in particular are something quite different from fund investments, we’ll disregard those additions for now.)

Secondly, there is risk diversification. Take some of those specialized managers that we just mentioned (i.e. your industry- and geography-specific small cap buyout fund). Yes, such a manager, if they do well, is likely do perform better than your diversified generalist megafund. But things can go the other way, too, so if you are committing to 3-4 funds per year, betting one of your tickets on such a manager might be overly risky. A FoF can alleviate that problem, providing investors with diversified access to such specialized GPs without incurring outsized single manager risk. (Of course any outsized returns would also be dampened by the diversification.)

Taken together, manager and risk diversification also translate into access-related benefits. In my last family office job, we met numerous of those high-performing, but also highly concentrated GPs. With 3-4 tickets per year, taking a bet on such a GP would’ve been too much of a concentration risk. However, we still saw benefits in this approach, and instead opted for a FoF to access those funds and their expected performance potential.

Third and last, there’s time diversification. While not the case for every FoF, many FoFs spread their commitments to GPs over 12-36 months (i.e. 1-3 vintage years). Those underlying managers also have investment periods of 3-5 years. Assuming our FoF invests in 12 managers over 3 years, and our underlying managers invest in 10-12 companies, our single commitment becomes a portfolio of 120-144 companies built over 7-8 calendar years (i.e. managers that invest from year 3 with a 4-5 year investment period). This diversification extends further as you invest in another fund of funds in subsequent years.

However, investors should be mindful of overdiversification. If your fees are very low (think a global stock market ETF), you’d gladly pay a few basis points more to lower your risk while still generating performance similar to your desired benchmark. However, in the world of alternative assets, where fees are still measured in percents rather than basis points, you should be mindful of how incremental diversification might negatively affect your performance.

Among the FoF GPs that we speak to frequently, it seems to be the opinion that diversification for an individual FoF seems to peak around 4-5 managers per vintage year (i.e. 12-16 managers for a FoF investing over 3 years). Yet many FoFs, especially those promoted by private banks or providers catering to affluent individuals, diversify much further - going as far as 20-30 funds per vintage year. At that point, you’re likely so diversified that all manager-specific Alpha across a portfolio evens out, leaving you with ‘just’ the asset class Alpha (i.e. 2-4% as commonly assumed for private equity). If we subtract a FoF’s higher fee load, and a sometimes longer holding period, there is a high chance of disappointing returns - like those single-digit IRRs that I mentioned in the beginning.

Of course, don’t forget that diversification typically is a FoF’s main benefit and purpose - followed by simplification and access. Even a more concentrated FoF with the clear goal of achieving superior performance than a diversified ‘megacap’ fund will likely not deviate too far from its benchmark. So if you are looking for truly outstanding performance, rather than compounding at around or slightly above the respective asset class’ long-term returns, a FoF might not be the ideal instrument. In that case, you simply have to take on more manager risk with its upsides and downsides.

Which brings us to our final section.

Performance (and Access)

As just mentioned, a FoF, simply by its nature, is likely not the highest-performing instrument in its asset class. As with any index fund, it simply provides investors with the average return across its respective portfolio. But in the right circumstances, we think that FoFs can be superior alternatives in regards to performance-related matters. Let me give you two examples.

First, private equity FoFs an alternative to to ‘megafunds’.

As a rough ‘rule of thumb’, we’d expect an average individual PE fund to generate a net multiple (TVPI) of 1,7-1,8x (figures backed by a ‘back of the envelope’ calculation based on Pitchbook data for 2010-2018 vintages), with an above-average PE fund expected to generate a return around 2,0-2,2x. Of course, there’s also a chance of underperformance. The difference between good and bad outcomes is called performance dispersion. (Always remember that historical results are no indicator of future performance.)

For small funds, this performance dispersion can be massive, ranging from lossmaking over the fund lifetime (i.e. <1x TVPI) to substantially above the aforementioned outcomes (think 3-5x). For the bigger funds, especially so-called ‘megafunds’ (think billions of dollars in committed capital), this range is much more narrow. And its especially those former funds that have (at least from our point of view) struggled to generate attractive returns in recent years - they’re simply too big to generate sufficiently large outcomes to really drive returns, and tend to also be more affected by macroeconomic environments, such as higher interest rates or the ongoing tariff challenges.

And relative to those megafunds, we think that FoFs specialized in small-cap funds (i.e. individual underlying funds with a total fund size of 250-500M$ which acquire companies as small as single-digit million EBITDA figures) can really shine. First, some qualitative factors on the small-cap approach:

• There’s many, many more small-cap companies out there than billion-dollar buyout targets, leaving small-cap GPs with a substantial pool of potential target companies. Given their size, they also come at lower multiples, giving the chance to create value through multiple expansion (perhaps also driven by Buy & Build).
  

• Small companies are in many cases less exposed to macroeconomic factors. For example, a local healthcare service company in the US is likely unaffected by what is happening with tariffs or in Europe. They typically also require less debt for cases to drive returns and are thus less affected by interest rate fluctuations.
  

• Lastly, as I mentioned in the Diversification section, small-cap buyout funds are typically much more specialized (as I mentioned - companies of a certain size, in a certain industry, in a certain sector) and thus have substantial experience in driving value creation efforts.

Which then brings us to the FoF level:

• Small-cap funds have a higher expected outperformance/alpha, but are also riskier.
  

• The higher expected outperformance helps us offset the higher fee burden associated with FoFs.
  

• The diversification across 8-12 funds, and 100+ portfolio companies, offsets the risk associated with small-cap, niche funds.

And that’s not just theory - that is reality: Many of the FoFs focused on small-cap buyout funds have demonstrated performance that is often as good as a megacap fund. But that’s not all: They achieve this return at a much higher level of diversification (100+ portfolio companies rather than 8-12). Furthermore, if they have a true outlier fund in their portfolio, performance might be lifted up even further, reaching net multiples in the 2,0-2,2x range. (Once again, historical returns are no indicator of future performance.)

Of course, things aren’t all rosy. A solid mid-cap fund might achieve stable returns higher than that fund of funds. Even for a diversified portfolio, there’s no guarantee that you’ll achieve such returns, especially in challenging exit environments. And many other reasons. But as more and more LPs realize that the megacap funds are struggling to achieve outperformance over public markets, small-cap buyout FoFs, in our view, are starting to be a more and more attractive alternative.

Moving on to our second example: Venture capital fund of funds.

Any good venture investor should be familiar with the so-called Power Law: VC fund returns are almost entirely driven by the outliers of a fund, i.e. those 100x-returning start-ups (think Uber or Airbnb). If you have a fund with one such outcomes, good for you - you’re on track for your fund investment to hit returns of 3x, 4x, or even higher.

But if you’ve spent some time in VC, you learn that many, many VCs fail to achieve those returns, by substantial margins. Gathering data over the years, I was shocked that even some of the biggest brand names in VC have failed to come close to those figures, often ending up with a TVPI of ‘just’ 2,0-2,5x. Combine that with a fund term of 12-15 years, and even the average public equity investor likely outperformed you. (Fun Fact: According to Cambridge Associates (as of March 2025), the US aggregate VC return underperformed the NASDAQ over every period (1, 3, 5, 10, 15, 20, and 25 years). And that’s before we take into account that the average return (as represented here) typically is better than the median return.)

Hence, we challenge most of our clients whether VC fund investing really makes sense for them from a purely financial standpoint. Often, there are other reasons as well, such as having the chance to get insights into cutting-edge technology, or to meet interesting people. If you’re not reliant on VC outperformance to achieve your financial goals, VC investing (whether its funds or start-ups) is an absolutely valid use of your hard-earned wealth.

But if you’re looking at things from a purely financial perspective, individual funds might not be the most reasonable choice. A simple NASDAQ ETF might be a more prudent choice - or perhaps a VC FoF. Let me explain why:

First, top-tier VC funds have historically shown staying power. According to Morgan Stanley’s fantastic paper Public to Private Equity in the USA, a first quartile VC fund has an almost 50% chance, i.e. twice as likely, for its subsequent fund to also be a first-quartile fund. Practically, that makes sense, as founders want to work with the best VCs, and vice versa. (I admit that there are some dynamics at play that might change those figures in the future.) And secondly, that the aforementioned “Power Law” doesn’t just drive returns at the level of an individual fund, but also a FoF. In other words, having one of those outlier VC funds (think 5-10x), if not multiple ones, can substantially lift performance of the FoF.

And if we combine those two points, we get the results: That well-performing VC FoFs have in our experience shown outperformance over most individual VC funds, despite the second fee layer, and the higher fees for the underlying ‘Tier 1’ funds. Think returns in the 3-4x net TVPI range and solid mid-double digit IRRs.

However, be especially careful with VC FoFs. Because just as with PE FoFs, not every product is worth its money. But whereas subpar PE FoFs typically underperform because of overdiversification, subpar VC FoFs that I’ve seen tend to overdiversify, and invest in GPs that simply don’t generate the necessary excess return. The result? Subpar portfolio performance, and a higher fee load, for a result that can easily be outperformed by most public market investments.

So to revisit our experience from the introduction: Despite their higher fees, we think that FoFs can absolutely be worth their money. The double fee layer is without a doubt a detractor from performance, but can be offset by diversification benefits (like small-cap PE FoFs), or outright outperformance through superior manager selection (like VC FoFs). But just as with individual funds, there is some degree of manager selection effort involved. Make sure to pick a good product that’s fairly priced, not overdiversified, and invested in the right managers. Or if you want to skip those efforts, reach out to us, and we’d be happy to assist you.

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